The Stagflation Scare
Every summer since 1960, the World Lumberjack Championships have been held in Hayward, Wisconsin, a small community in the north west of the state. Among the featured events in this and similar gatherings is logrolling, where two competitors scamper furiously on top of a very wet and smooth log, floating on a shallow, muddy lake.
The contests are fun to watch but they don’t last long. Even someone perching solo on a slippery log is essentially adopting a disequilibrium position and natural forces will quickly land him or her in the drink. I can’t even imagine the difficultly in staying upright on such a log with an opponent trying to hurry along your inevitable plunge into the water.
There has been much talk in recent months about the threat of stagflation, that is to say, a sustained period of both high unemployment and high inflation. However, before considering the possibility of such an unpleasant outcome, it is important to understand why it is theoretically so unlikely.
High unemployment, like standing on a log in the water, is fundamentally a “disequilibrium” position. Some shock that sends the economy into recession can, of course, trigger a spike in unemployment. However, as the shock wears off, unemployment steadily retreats and usually doesn’t stop until we reach what economists would characterize as “full employment”. This makes perfect sense. Every day, Americans wake up willing to work more hours, buy more stuff and get ahead and their collective efforts will naturally push us towards full employment.
Similarly, high inflation, provided it reflects supply shocks rather than reckless monetary and fiscal stimulus, will tend to abate on its own. Very high prices for commodities or consumer goods mean high profits for producers who can get these goods to market. Supply responds to strong demand and prices get driven back down.
However, a combination of high unemployment and high inflation is particularly hard to sustain as they each tend to undermine the other. High unemployment reduces demand, allowing supply to catch up more quickly and prices to fall. Fast-rising prices for goods and services encourage businesses to hire more people so they can sell while the selling is good.
Consequently, while commentators have recently been scaring the public with predictions of stagflation, sustained stagflation is a very unlikely event.
Indeed, annual data since 1929 show a clear, negative relationship between the unemployment rate and inflation, with every one percentage point increase in the unemployment rate cutting the inflation rate by roughly 0.35%. Even in the period most associated with stagflation, the 1970s and early 1980s, the peak years for inflation, 1974, 1979, 1980 and 1981 were not the same as the peak years for unemployment which were 1975, 1976, 1982 and 1983.
Moreover, from 1970 through 1983, the average inflation rate was 7.4% and the average unemployment rate was 6.9%. In 2021, we expect the U.S. unemployment rate to be 5.4% and the U.S. inflation rate to be 4.5%. In 2022, we expect both of these numbers to fall to below 4%.
That being said, policymakers need to have a balanced view of the effect of their actions on the economy. With the economy still recovering steadily from the pandemic recession, it needs less fiscal stimulus going forward than the $5.3 trillion spent over the past two years to help it out. Equally, low interest rates are continuing to encourage an unhealthy inflation in asset prices. As the economy has clearly improved, the Federal Reserve ought to gradually taper its asset purchases and begin the process of restoring real short-term interest rates to normal levels.
Investors should recognize that in practice both fiscal and monetary stimulus are likely to be scaled back in the year ahead. Even if Congress succeeds in passing an infrastructure bill and a watered down reconciliation bill in the next few weeks, the federal budget deficit is likely to fall to below 5% of GDP this fiscal year compared to over 12% of GDP in the fiscal year just ended. Moreover, the Federal Reserve seems undaunted by the third-quarter slowdown and will likely look at data such as last Friday’s September retail sales report as a sign that the expansion is strong enough to weather the impact of tapering bond purchases starting in mid-November.
All of this being said, investors should also recognize that stock and bond valuations are at very high levels. Even though unemployment is likely to continue to fall, economic growth will likely slow, posing a challenge to recently booming corporate profits. And even though year-over-year inflation is also likely to ease in the year ahead, interest rates will likely move higher, posing a threat to long-duration bonds and growth stocks.
Because of this, while investors probably shouldn’t be scared of stagflation, they should recognize the importance of valuations and diversification as we move into a period of slower growth and higher interest rates in the years ahead.